Tuesday, 18 September 2018

Tough times

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It's been a tumultuous year for the corporate bond market in arguably the most seminal period in global banking history. The markets hope that the US Federal Reserve's bail-out plan will finally draw a line under the crises, but how do participants view the current environment, and how do they perceive the future prospects for the corporate bond market? Andrew Perrin asks.

For more cyclical names further down the rating spectrum (mid/low Triple B), it may not be the high funding costs that provide the biggest hurdle for borrowers. Convincing selective investors to top up on this level of risk at all is a greater challenge, as recent events have made accounts even more cautious than before.

This is reflected by the downbeat outlook for the corporate sector. Expectations are rife that the deteriorating macroeconomic backdrop will lead to recession, eating into corporate earnings in the process and increasing funding costs further. A recent report by Moody's highlights the refunding risks for EMEA non-financial corporate issuers rated Baa and below in 2008-2010: "It is expected that markets will remain broadly uncertain over the next six to 12-months until the overall financial and economic landscape is better understood. Against this background and considering recent issuance volumes, market liquidity could become stretched to meet future refinancing and new funding requirements", said Sabine Renner, analyst at Moody's.

Rodrigo E. Araya Arancibia, head of fixed income at Lombard Odier Darier Hentsch, said now might not be the right time to top up on corporate bond risk, but it is definitely time to start looking at when to increase allocations or add risk. He believes the outlook for the higher rated non-cyclical industrials is better that it has been during previous recessionary periods.

"Balance sheets are still reasonably strong and actual default rates still very low. While the deteriorating macro outlook indicates [that default rates] will increase, the situation should remain fairly contained." However, he stressed the importance of being selective: "We will take a conservative approach to the industries, and prefer a more defensive strategy, favouring the likes of healthcare, telecoms and utilities at the expense of more cyclical names. We are surprised that Single A chemical companies such as BASF, DSM and Air Products are still trading as tight as 50bp-70bp in five-year CDS."

This was echoed by Nigel Sillis, head of fixed-income and currency research at Baring Asset Management, and who also runs a corporate bond fund at the group. "We don't like cyclical names and high-yield bonds, despite current distressed valuations,” he said. “There are a large number of companies with little pricing power and product differentiation that have significant refinancing requirements, that will be operating in adverse conditions in a market that is not conducive to keeping them going. Default risk should therefore continue to increase heading into 2009. Specific industries that spring to mind include the retailers, commodities, chemicals, building materials and forestry products."

Saint Gobain, the building materials producer rated Baa1/BBB+, will be looking back on it's €750m five-year issue launched in early September with satisfaction. The deal was placed at swaps plus 270bp on the back of a book of around €1.1bn, equating to a premium of about 56bp versus CDS and 70bp to cash. Interestingly, this is also one of the very few post-summer transactions that actually performed in the secondary market, having tightened in by over 25bp to an equivalent Bunds plus 305bp/295bp at the time of writing. It underlines the importance of strong domestic support: French investors took about 61% of the deal.

Historically, about 60%–70% of European corporate funding has been through the loan market – significantly higher than in the US, where about 75% of companies fund through the bond market. This dynamic has already started to change as banks have become more conservative about how they operate. Relationships with borrowers have consequently become strained, as corporates draw down on these committed lines of credit.

The difficulty for corporates is accentuated by a lack of liquidity in the short-term commercial paper (CP) market that had often provided funding opportunities this year. "The ECP market has virtually dried up, even for solid A1/P1 rated issuers, reflected by recent trading volumes (towards the end of September) that are just 20% of average levels this year,” said one frequent Single A rated issuer that did not wish to be named. “Moreover, any cash that is being provided by the central banks is staying within the banking system and not finding its way to corporates."

The ongoing lack of liquidity in the secondary market has added to the problem, creating a Catch 22 situation where accounts are reluctant to add to risk through the secondary market. They feel new issues will re-price the sector, but are equally concerned about the follow-through lack of liquidity if the deal does not perform.

"We need a sufficient level of liquidity in the secondary market with bid/offer spreads narrowing before confidence can be restored,” said Sillis. “It's very difficult to value new securities against cash when [bid/offer] spreads are so wide and the mid-point often so artificial." The more elevated CDS market will continue to be used as a barometer for relative value, a scenario which is hardly favourable for potential issuers, he added.

What's your reference?

CDS should remain the reference point of choice to determine where value lies, agreed Araya Arancibia. It has proven to be the most liquid instrument in the credit universe, and will continue to take precedence while cash is not trading.

But not everyone agreed on the imperative role of CDS as a reference point. Christopher Marks, head of European debt capital markets at BNP Paribas, said the cash market should remain the default benchmark for new issuance, in light of the core client base. "Many real money accounts such as insurance and asset managers are not trading derivatives and do not have basis positions. It's not that CDS has been completely discredited, but it definitely has less meaning for these investors," he said.

He did acknowledge that cash is still quite illiquid, however, and investors require a dramatically larger new issue premium to reflect the increased level of risk. Moreover, "in the new environment, the first issues priced may themselves serve as the most important references for subsequent trades with investors placing value on the outright spread and coupon, rather than relative to other outstanding cash or CDS levels."

While the European primary market was still closed at the time of writing, the dollar market had reopened the week before – at eye watering levels. CAT Finance, rated A2/A, kick-started supply with a dual-tranche five and 10-year package at Treasuries plus 320bp and 325bp, paying a premium of about 100bp versus both cash and CDS in the process. This was followed by American Honda (Aa3/A+), which was forced to pay governments plus 387.5bp to get its five and 10-year deals done. This represents a whopping 130bp and 160bp versus CDS and, on the shorter-dated tranche, close to 125bp over cash.

"Maybe in hindsight these levels may look acceptable in a few months time, but at the moment I cannot see any logic for a European corporate that funds on a Libor basis to accept these levels, unless they are desperate for funds,” said the issuer. “We are not in that situation, and our strategy is to therefore sit tight but remain flexible and tap the market opportunistically when an opportunity presents itself. The private placement market is probably deeper than many expected and can offer some good opportunities for issuers as it did earlier this year."

Mark Dodd, joint global head of bond and loan syndicate at RBS, agreed this is a sensible strategy. "Our advice to issuers is to remain flexible with regards to the currency and maturity and maintain the ability to get out of the blocks quickly when an opportunity becomes available," he said. Sterling in particular could provide a glimmer of hope for some issuers in the weeks ahead, he added.

"The sterling market has demonstrated that it is less emotional than euros during periods of volatility, it is competitive on price and large orders from just five core investors can provide sufficient confidence to get a deal done" Dodd said. While UK investors still demand the right covenants in the language, and often the opportunity to attend a roadshow beforehand, they are reasonably cash rich, and continue to deepen their already strong credit analysis capabilities, he stressed.

For a first-time foreign issuer, the sterling market also provides the chance to diversify its investor base. This opportunity is arguably even more important since the onset of the credit crisis, as liquidity might not always be so easy to come by elsewhere. The additional duration (the majority of issues carry a maturity of at least 10-years) means that the majority of UK investors are buy-and-hold accounts with longer-term liabilities, which tends to limit any fallout from broader market volatility. This scenario has not always been the case in euros, where negative newsflow has, on many occasions, dampened primary flow this year.

Most recent sterling issuance throughout the summer has included a number of non-domestic transactions from the likes of Goodman Group, TNT, Cadbury Schweppes and SPI Electric & Gas, among others, all of which were initially roadshowed in euros before the companies opted to raise sterling instead.

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